Special Topics in Financial Management

Ecclesiastes 11:1-2
"Invest your money in foreign trade, and one of these days you will make a profit."

MODULE 1: FOREIGN EXCHANGE MARKETS

Learning Outcomes:

• Demonstrate what foreign exchange markets and foreign exchange rates;

• Point out the history of and current trends in foreign exchange markets;
• Identify the largest foreign exchange markets;
• Distinguish between a spot, a forward, or a swap foreign exchange transaction;
• Determine the size of the FOREX market;
• Calculate and compare foreign exchange rates and quotations.
 Module 1 The Market for Foreign Exchange

Foreign Exchange Market – provides the physical and institutional structure through which the money of
one country is exchanged for that of another country, the rate of exchange is determined and foreign
transactions are physically completed.

Foreign exchange transaction - is an agreement between a buyer and a seller that a fixed amount of one
currency will be delivered for some other currency at a specified rate.

GEOGRAPHIC EXTENT OF THE MARKET

➢ Geographically, the FOREX market spans the globe with prices moving and currencies trading
every hour of every business day.
➢ Major world trading starts each morning in Sydney and Tokyo
➢ Then moves west to Hong Kong and Singapore
➢ Continuing to Europe and finishing on the West Coast of the U.S.

Measuring Foreign Market Activity: Average Electronic Conversions per Hour

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FUNCTIONS OF THE FOREX MARKET

The FOREX market is the mechanism by which participants:

➢ Transfer purchasing power between countries

➢ Obtain or provides credit for international trade transactions
➢ Minimize exposure to exchange rate risk

MARKET PARTICIPANTS

The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail
market.

Five broad categories of participants operate within these two tiers:

1. Bank and non-bank foreign exchange dealers

2. Individuals and firms conducting commercial or investment transactions
3. Speculators and arbitragers
4. Central banks and treasuries
5. Foreign exchange brokers

BANK AND NON-BANK DEALERS

➢ These participants profit from buying currencies at a bid price and then reselling them at an offer
or ask price.
➢ Dealers on behalf of large international banks often act as market makers, often willing to stand
in and buy or sell these currencies without having a counterpart with which to unload the
“inventory”.
INDIVIDUALS AND FIRMS CONDUCTING COMMERCIAL/INVESTMENT TRANSACTIONS
➢ Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to
facilitate execution of commercial or investment transactions.
SPECULATORS AND ARBITRAGERS
➢ Speculators and arbitragers seek to profit from trading in the market itself
➢ They operate for their own interest, without need or obligation to serve clients or ensure a
continuous market
➢ Speculators seek all their profit from exchange rate changes

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 Module 1 The Market for Foreign Exchange

➢ Arbitragers try to profit from simultaneous differences in exchange rates in different markets
➢ A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders
employed by those banks
4. CENTRAL BANKS AND TREASURIES
➢ Central banks and treasuries use the market to acquire or spend their country’s currency reserves
as well as to influence the price at which their own currency trades.
➢ Consequently, their motive is not to profit but rather influence the foreign exchange value of their
currency in a manner that will benefit their interests
5. FOREIGN EXCHANGE BROKERS
➢ Foreign exchange brokers are agents who facilitate trading between dealers without themselves
becoming principals in the transaction.

TRANSACTIONS IN THE INTERBANK MARKET

➢ Transactions within this market can be executed on a spot, forward, or swap basis.

SPOT TRANSACTIONS- in the interbank market is the purchase of foreign exchange, with delivery and
payment between banks to take place, normally, on the second following business day.
• The settlement date is often referred to as the value date.

▫ This is the date when most dollar transactions are settled through the computerized
Clearing House Interbank Payment Systems (CHIPS) in New York.

OUTRIGHT FORWARD TRANSACTION

➢ This transaction requires delivery at a future value date of a specified amount of one currency for
another.
➢ The exchange rate is agreed upon at the time of the transaction, but payment and delivery are
delayed.
➢ Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve
months.

SWAP TRANSACTION
➢ A swap transaction in the interbank market is the simultaneous purchase and sale of a given
amount of foreign exchange for two different value dates.
➢ Both purchase and sale are conducted with the same counterpart.
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➢ Non-deliverable forwards (NDFs) – NDFs possess the same characteristics as traditional forward
contracts except that they are settled only in US dollars and the foreign currency being sold or
bought forward is not delivered.

Size of the FOREX Market

➢ The Foreign Exchange (Forex Market) is the largest financial market in the world.
➢ According to Bank for International Settlements (BIS), trading in foreign exchange markets
averaged $5.1 trillion per day in April 2016. This is down from $5.4 trillion in April 2013 but up
from $4.0 trillion in April 2010. In April 2019, it reached a daily volume of $6.6 trillion.

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 Module 1 The Market for Foreign Exchange

➢ Breakdown is as follows:

Geographical Distribution of FX Market Turnover, 2019

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Special Topics in Financial Management

➢ The United Kingdom (London) and the United States (New York) make up nearly 60% of the
foreign exchange market.
➢ The London trade alone makes up 43% of daily transactions in the foreign exchange market.
➢ Singapore, the third largest market previously at 8% (2016) slightly decreased to 7.7% of world
trading while Hong Kong gaining with 7.6%

Data Source: Bank for International Settlements 2019

Foreign Exchange Rates & Quotations

➢ A foreign exchange quote is a statement of willingness to buy or sell at an announced rate.
➢ In the retail market (newspapers and exchange booths), quotes are often given as the home
currency price of the foreign currency.
➢ Interbank quotes – professional dealers or brokers may state quotes in one of two ways:
➢ European terms quotations are the foreign currency price of one US dollar.
➢ American terms are the dollar price of a foreign currency.
o Quotations can also be direct or indirect. A direct quote is the home currency
price of a unit of foreign currency, while an indirect quote is the foreign currency
price of a unit of the home currency.

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Interbank quotes are given as a bid and ask

➢ The bid is the price at which a dealer will buy another currency.
➢ The ask or offer is the price at which a dealer will sell another currency. (Saunders & Cornett,
2019)
Example: ¥118.27 - ¥118.37/$ is the bid/ask for Japanese yen
➢ The bank will buy yen at ¥118.27 per dollar and sell yen at ¥118.37 per dollar
making profit on the spread;

Cross Rates – an exchange rate between two currencies, calculated from their common relationships with
a third currency.
Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the
Mexican peso (MXP) and Japanese yen (¥) are quoted in US dollars
Assume the following quotes:
Japanese Yen ¥110.73/$
Mexican Peso MXP 11.4456/$
➢ The Mexican importer can buy one US dollar for 11.4456 Mexican pesos and with
that dollar buy ¥110.73; the cross rate would be ¥ 9.6745/MXP

Summary
• The foreign exchange market provides the physical and institutional structure through which the
money of one country is exchanged for that of another country, the determination of exchange
rates between currencies, and the physical completion of foreign exchange transactions.
• A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount
of one currency will be delivered for some other currency at a specified rate.
• The six characteristics of FOREX markets include geographic extent of markets, its three main
functions, the market’s participants, its daily transaction volume, the types of transactions
including spot, forward and swaps and the methods of stating exchange rates, quotations, and
changes in exchange rates.
• Major world trading starts each morning in Sydney and Tokyo and finishes on the west coast of
the U.S.
• The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail
market. The wholesale market usually occurs on financial institutions such as commercial banks,
and the retail market is a segment of FOREX that consists of investors who wants to earn from
exchange rates of different currencies.
• A spot transaction requires almost immediate delivery of foreign exchange.
• A forward transaction requires delivery of foreign exchange at some future date.
• A swap transaction is the simultaneous exchange of one foreign currency for another.
• In April 2019, the average daily volume of transaction of the FOREX is $6.6 trillion.
• The United Kingdom is the largest trader making the most important center for FOREX trading in
the world.
• A foreign exchange quote is a statement of willingness to buy or sell at an announced rate. In the
retail market, quotes are often given as the home currency price of the foreign currency. For
interbank quotes, it can be stated as either European terms or American terms. Quotes can also
be direct or indirect.

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• Cross rates are exchange rates between two currencies, calculated from their common
relationships with a third currency.

Review Questions:
1. Describe the geographic extent of the FOREX market.
2. What are the three main functions of the foreign exchange markets? Explain each.
3. What is hedging? Explain.
4. Give an example of a spot, forward, and a swap transaction.
5. Determine the cross rate of the following: Use today’s rate.
a. Thai Baht/Japan Yen
b. Euro/UAE Dirham
c. Saudi Riyal/Bahrain Dinar
d. Swiss Franc/Canadian Dollar
e. Philippine Peso/Malaysian Ringgit

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 Module 1 The Market for Foreign Exchange

References
(2019). Retrieved 2022, from www.bis.org: https://www.bis.org/statistics/rpfx19.htm?m=2677

(2022, January 4). Retrieved 2022, from Yahoo Finance: https://finance.yahoo.com/news/fair-forex-

forex-library-making-184500405.html

Lopez-Mariano, N. D. (2017). Capital Markets First Edition. Rex Book Store, Inc. (RBSI).

Saunders, A., & Cornett, M. M. (2019). Financial Markets and Institutions Seventh Edition. McGraw Hill
Education.

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